America Gets Downgraded

A spend and tax policy mix always leads to economic decline.

August 8, 2011

Whatever one thinks of the credit-rating agencies—and we aren't admirers—it serves no good purpose to shoot the fiscal messengers. Friday's downgrade by Standard & Poor's of U.S. long-term debt to AA+ from AAA will be the first of many such humiliations if Washington doesn't change its economic and fiscal policies.

Investors and markets—not any single company's rating—are the ultimate judge of a nation's creditworthiness. And after their performance in fanning the credit and mortgage-security mania of the last decade, S&P, Moody's and Fitch should hardly be seen as peerless oracles.

Editorial writer Mary Kissel on the implications of the S&P downgrade.

Their views are best understood as financial opinions, like newspaper editorials, and they're only considered more important because U.S. government agencies have required purchasers of securities to use their ratings. We've fought to break that protected oligopoly, even as liberals in the Senate led by Minnesota's Al Franken have tried to preserve it. Federal bank regulators have been on Mr. Franken's side in this fight, so they can blame themselves in part for S&P's continued prominence.

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Yet is there anything that S&P said on Friday that everyone else doesn't already know? S&P essentially declared that on present trend the U.S. debt burden is unsustainable, and that the American political system seems unable to reverse that trend.

This is not news.

In that context, the Obama Administration's attempt to discredit S&P only makes the U.S. look worse—like the Europeans who also want to blame the raters for noticing the obvious. Treasury officials and chief White House economic adviser Gene Sperling denounced S&P for relying on a Congressional Budget Office scenario that overestimated the U.S. discretionary spending baseline by $300 billion through 2015 and $2 trillion through 2021.

But even adjusting for that $2 trillion would only reduce U.S. publicly held debt to 85% or so of GDP—still dangerously high. And that assumes that recently agreed upon spending caps are sustained over a decade, something which rarely happens.

We think the larger problem with S&P, Moody's and Fitch is that they make no distinction over how a nation balances its books—whether through tax increases or spending reductions. Like the International Monetary Fund, the raters care only about balance.

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This takes too little account of the need for faster economic growth, which is the only real path out of a debt crisis. Britain's government has earned rater approval for its fiscal consolidation, but its increases in VAT and income tax rates are hurting its tepid recovery. Letting the credit raters dictate tax increases is the road to an austerity trap.

The real reason for White House fury at S&P is that it realizes how symbolically damaging this downgrade is to President Obama's economic record. Democrats can rail all they want about the tea party, but Republicans have controlled the House for a mere seven months. The entire GOP emphasis in those seven months—backed by the tea party—has been on reversing the historic spending damage of Mr. Obama's first two years.

The Bush Presidency and previous GOP Congresses contributed to the current problem by not insisting on domestic cuts to finance the cost of war, and by adding the prescription drug benefit without reforming Medicare. But as recently as 2008 spending was still only 20.7%, and debt held by the public was only 40.3%, of GDP.

In the name of saving the economy from panic, the White House and the Pelosi Congress then blew out the American government balance sheet. They compounded the problem of excessive private debt by adding unsustainable public debt.

They boosted federal spending to 25% of GDP in 2009, 23.8% in 2010 (as TARP repayments provided a temporary reduction in overall spending), and back nearly to 25% this fiscal year. Meanwhile, debt to GDP climbed to 53.5% in 2009, 62.2% in 2010, and is estimated to hit 72% this year—and to keep rising. These are all figures from Mr. Obama's own budget office.

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Rather than change direction this year, Mr. Obama's main political focus has been to preserve those spending levels by raising taxes. His initial budget in February for fiscal 2012 proposed higher spending. He then resisted the modest spending cuts that the GOP proposed for the rest of fiscal 2011.

He responded to Paul Ryan's proposal to reform Medicare and Medicaid by calling it un-American and unworthy of debate. In the most recent budget talks, he would only consider small entitlement reforms (cuts in payments to providers) if Republicans agreed to raise taxes. He has refused even to discuss ObamaCare or serious reforms in Medicare and Social Security. Meanwhile, federal payments to individuals continue to grow as a share of all spending, as the nearby chart shows.

This is how you become the Downgrade President.

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Despite S&P's opinion, there is no chance that America will default on its debts. The real importance of the downgrade will depend on the political reaction it inspires.

If the response is denial and blaming the credit raters, then the U.S. will continue on its current road to more downgrades and eventually to Greece. What has already become a half-decade of lost growth will turn into a lost decade or more.

If the response is to escape the debt trap by the stealth route of inflation—a path now advocated by many of the same economists who promoted the failed spending stimulus of 2009—then the U.S. could spur a dollar crisis and jeopardize its reserve currency status.

The better answer—the only road back to fiscal sanity and AAA status—is to reverse the economic policies of the late Bush and Obama years. The financial crisis followed by the Keynesian and statist revival of the last four years have brought the U.S. to this downgrade and will lead to inevitable decline. The only solution is to return to the classical, pro-growth economic ideas that have revived America at other moments of crisis.

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